Imputed Interest and the IRS AFR for Family Loans

Most people making a family loan have no idea the IRS has rules about the minimum interest rate they are supposed to charge. Getting this wrong does not usually cause a large tax bill, but it creates unnecessary paperwork and an awkward IRS notice. Here is what you need to know.

Why the IRS cares about family loan interest rates

The IRS worries that family members can shift wealth between generations by disguising gifts as loans at 0% interest. If a parent lends a child $200,000 at 0% for 10 years, the child effectively receives the use of that capital for free, which is economically equivalent to a large gift.

To prevent that, Congress enacted the "below-market loan" rules in IRC Section 7872. Under those rules, any loan charged below the Applicable Federal Rate (AFR) triggers imputed interest: the lender is treated as having received interest income they never actually collected, and the same amount is treated as a gift to the borrower.

What the AFR is and how to find it

The AFR is published monthly by the IRS in a Revenue Ruling. There are three tiers based on loan term:

Short-term AFR. Loans with a term of 3 years or less.
Mid-term AFR. Loans with a term of more than 3 years up to 9 years.
Long-term AFR. Loans with a term exceeding 9 years.

The rates are generally modest. To find the current AFR, search "IRS AFR" followed by the current month and year at irs.gov. The rate in effect when the loan is made is locked in for the life of a fixed-rate installment loan. Note that the rates shown are annual, and may be compounded semi-annually, quarterly, or monthly. Use the compounding period that matches your note's payment frequency.

Do not guess or use last year's numbers. Rates change monthly, and the IRS website posts the current revenue ruling reliably.

The $10,000 and $100,000 exceptions

Not every family loan is subject to the full AFR rules. There are two important exceptions:

The $10,000 de minimis exception. Loans of $10,000 or less are completely exempt from the imputed-interest rules, as long as the borrower does not use the money to buy income-producing assets (stocks, bonds, rental property). This covers most casual small family loans entirely.
The $100,000 limited exception. For loans between $10,001 and $100,000, imputed interest is capped at the borrower's net investment income for the year. If the borrower earned less than $1,000 in investment income during the year, imputed interest is zero even at a 0% rate. Above $1,000, imputed interest equals the lesser of (a) the full imputed amount at AFR or (b) the borrower's net investment income.

Loans above $100,000 get no exception. Set the rate at or above the AFR.

What imputed interest actually costs you

Say you lend a sibling $150,000 for 5 years at 0% when the mid-term AFR is 4%. The IRS computes imputed interest of roughly $6,000 per year. Two consequences:

You owe income tax on $6,000 of interest you never received. At a 22% marginal rate, that is about $1,320 per year in extra taxes.
The same $6,000 is treated as a gift from you to the borrower. Since $6,000 is under the $18,000 annual exclusion, no gift-tax filing is triggered in this example. But in years where you also give other gifts to the same person, the imputed interest counts toward the exclusion.

For most family loans, the cost is manageable. But it is real, and it is avoidable simply by charging the AFR.

Demand notes and the blended annual rate

Demand notes (where there is no fixed repayment term) cannot use the origination-month AFR, because the IRS has no way to assign a tier without a known term. Instead, the IRS publishes a "blended annual rate" each July for use on demand notes outstanding during that calendar year. The rate applies to the entire year, not just the portion after July. If you have a demand note and want to avoid the blended-rate complication, consider converting it to an installment note with a fixed term so you can lock in a specific tier.

Practical checklist before signing

Identify your loan amount and repayment term.
Find the current AFR for the appropriate tier at irs.gov.
Set the interest rate in the note at or above the AFR.
If the loan is $10,000 or less (and not for income-producing assets), you can charge 0% with no tax consequences.
Use our Usury Limit Checker to confirm the rate is also under your state's usury cap (a rate at the AFR is almost always legal, but worth confirming for larger loans).
Consider consulting a CPA or tax advisor for loans above $100,000.

Installment Note (fixed payments) Secured Note (with collateral)

Frequently Asked Questions

What is the Applicable Federal Rate (AFR)?

The AFR is the minimum interest rate the IRS expects on private loans. It is published monthly in three tiers: short-term (loans of 3 years or less), mid-term (more than 3 years up to 9 years), and long-term (over 9 years). The rates are generally well below commercial bank rates. You lock in the rate in effect for the month the loan is made, and that rate applies for the entire life of the loan. Find current rates by searching "IRS Revenue Ruling AFR" plus the current month and year at irs.gov.

What happens if I charge less than the AFR?

The IRS treats the difference between the AFR and the rate you actually charged as "imputed interest." Two tax consequences follow: (1) you are treated as having received interest income equal to the imputed amount, which is taxable to you even though you never collected it; and (2) the same imputed amount is treated as a gift from you to the borrower for gift-tax purposes. If the imputed gift plus any other gifts to that person in the year exceed the annual exclusion ($18,000 in 2025), you must file Form 709.

Is there a loan size where I can safely charge 0% interest?

Yes. The IRS has two exceptions to the imputed-interest rules. First, loans of $10,000 or less are completely exempt, as long as the borrower does not use the money to purchase income-producing assets. Second, loans between $10,001 and $100,000 have a limited exemption: imputed interest cannot exceed the borrower's net investment income for the year. If the borrower earns less than $1,000 in investment income in a year, you can generally ignore imputed interest even at 0%. Above $100,000, the full AFR rules apply with no exceptions.

How do I find the right AFR tier for my loan?

Match the loan term to the tier. Short-term AFR applies to loans with a repayment term of 3 years or less. Mid-term AFR applies to loans with a term of more than 3 years up to 9 years. Long-term AFR applies to loans with a term exceeding 9 years. For installment loans, the term is the scheduled payoff date, not the original principal amount. For demand notes with no fixed term, the IRS allows the use of the blended annual rate published each July.

Does the AFR change if rates go up after I make the loan?

No. For most fixed-rate loans, you lock in the AFR from the month the loan is made. Future rate changes do not affect you. The exception is demand notes: because they have no fixed term, the IRS requires using the blended annual rate each year rather than the origination-month rate. If you want rate certainty for the full life of a family loan, use an installment note with a fixed term and lock in the AFR at origination.

If I charge exactly the AFR, do I still have to report interest income?

Yes. Interest income is taxable regardless of who it comes from. If your family member pays you $600 or more in interest during the year, they must also issue you a Form 1099-INT (though many private lenders skip this and simply report the income). You report the interest as ordinary income on Schedule B of your federal return. The borrower may be able to deduct the interest if the loan is used for a qualifying purpose (investment interest, business use).

Can I forgive the loan instead of collecting interest every year?

Yes, but be careful about the tax treatment. Forgiving a loan is treated as a gift in the year of forgiveness. If you forgive the entire balance at once, the full amount counts as a gift. If you forgive interest owed for a year, the forgiven interest is also a gift. To stay under the annual gift-tax exclusion ($18,000 per recipient in 2025, $36,000 from a married couple), forgive in installments across multiple years, or accept that you will need to file Form 709 for the year you exceed the threshold.

Does an installment note help with the AFR more than other note types?

An installment note is often the most straightforward for AFR compliance. You set a fixed rate at origination (at or above the applicable tier), and the scheduled payments include both principal and interest. Each payment is split between principal (not taxable to you) and interest (taxable). Our installment note form lets you enter the interest rate, and we include the required amortization and interest language in the document.

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